Will global imbalances return?

Barry Eichengreen, May 25, 2009, 04.37am IST

Future history books, depending on where they are written, will take one of two approaches to assigning blame for the world's current economic crisis.

One approach will blame lax regulation, accommodating monetary policy, and inadequate savings in the United States. The other, already being pushed by former and current US officials like Alan Greenspan and Ben Bernanke, will blame the immense pool of liquidity generated by high-savings countries in East Asia and the Middle East. All that liquidity, they will argue, had to go somewhere. Its logical destination was the country with the deepest financial markets, the US, where it raised asset prices to unsustainable heights.

Note the one thing on which members of both camps agree: the global savings imbalance — low savings in the US and high savings in China and other emerging markets — played a key role in the crisis by allowing Americans to live beyond their means. If there is a consensus on one issue, it is the impossibility of understanding the bubble and the crash without considering the role of global imbalances.

Preventing future crises similar to this one requires resolving the problem of global imbalances. Here, the early signs are reassuring. American households are saving again. The US trade deficit has declined from $60 billion a month to just $26 billion, according to the most recent data.

But once American households rebuild their retirement accounts, they may return to their profligate ways. Indeed, the Obama administration and the Federal Reserve are doing all they can to pump up US spending. The only reason the US trade deficit is falling is that the country remains in a severe recession, causing imports and exports to collapse in parallel. With recovery, both may recover to previous levels, and the 6%-of-GDP US external deficit will be back. In fact, there has been no change in relative prices or depreciation of the dollar of a magnitude that would augur a permanent shift in trade and spending patterns.

Whether there is a permanent reduction in global imbalances will depend mainly on decisions taken outside the US, specifically in countries like China. One's forecast of those decisions hinges, in turn, on why these other countries came to run such large surpluses in the first place. One view is that their surpluses were a corollary of the policies favouring export-led growth that worked so well for so long. China's leaders are understandably reluctant to abandon a tried-and-true model. They can't restructure their economy instantaneously.

They need time to build a social safety net capable of encouraging Chinese households to reduce their precautionary saving. If this view is correct, we can expect to see global imbalances re-emerge once the recession is over and to unwind only slowly thereafter.

The other view is that China contributed to global imbalances not through its merchandise exports, but through its capital exports. What China lacked was not demand for consumption goods, but a supply of high-quality financial assets. It found these in the US, mainly in the form treasury and other government-backed securities, pushing other investors into more speculative investments.

Recent events have not enhanced the stature of the US as a supplier of high-quality assets. And China, for its part, will continue to develop its financial markets and its capacity to generate high-quality financial assets internally. But doing so will take time. Meanwhile, the US still has the most liquid financial markets in the world. This interpretation again implies the re-emergence of global imbalances once the recession ends, and their very gradual unwinding thereafter.

One development that could change this forecast is if China comes to view investing in US financial assets as a money-losing proposition. US budget deficits might excite fear of losses on US treasury bonds. A de facto policy of inflating away the debt might stoke such fears further. At that point, China would pull the plug, the dollar would crash, and the Fed would be forced to raise interest rates, plunging the US back into recession.

There are two hopes for avoiding this disastrous outcome. One is relying on Chinese goodwill to stabilise the US and world economies. The other is for the Obama administration and Fed to provide details about how they will eliminate the budget deficit and avoid inflation once the recession ends. The second option is clearly preferable. After all, it is always better to control one's own fate.

(The author is Professor of Economics at the University of California)